Big GAAP, Little GAAP

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OCTOBER 2006 - I read with interest the article and the viewpoint on Big GAAP versus Little GAAP in the May and August 2006 issues. I agree with author Neville Grusd (“On Big GAAP Versus Little GAAP,” August) on the feasibility of simply taking a qualified opinion for any exceptions to GAAP found in the private company’s accounting that were due simply to the impracticality of the rule rather than to malfeasance. Furthermore, experiences of the past few months have made clear to me that a real standards-setting problem has not been addressed: The change in the basis for accounting from historical cost to fair value will cause an unnecessary problem for private companies.

In April, I participated in two conferences, one concerning fair-value accounting, the other pension accounting. In the first conference, I shared the dais with Ed Trott of FASB. In the second conference, Peter Prostakes, the pension project manager for FASB, was also on the program. In the first conference, I asked Ed Trott if FASB did not believe it had any responsibility for the wide range of fair values allowed under such standards as SFAS 133 (for derivatives), which permitted Enron to extensively manipulate earnings. He clearly responded that FASB did not have any responsibility regarding the application of their standards. This position was reiterated a few days later by Peter Prostakes.

I was taken aback by their position. Throughout my career—private, public, and teaching—I have believed regulators were supposed to help private accountants and public accountants to make rules that aid comparability but also that help to control fraud. Certainly the SEC was formed with those goals in mind. The abuses of the 1920s, such as writing up assets and watering stock, or paying dividends from capital, had to be stopped. Throughout the history of the regulators—the SEC, the CAP, and the APB—those goals remained. The change began with the Trueblood report, which resulted in the conceptual framework. No specific reference was ever made (that I can find) that the very basis of accounting data was going to be changed from historical cost to fair value. In fact, in the early days of the conceptual framework, this fear was ridiculed. However, the shift has been happening for the past 20 years and has resulted in a subtle loosening of the control function of accounting standards.

The position stated by Trott and Prostakes would be correct if the standards were based on historical cost, as they had been for more than 50 years. Although accrual accounting has a built-in subjectivity, the basis did not change. This is not true under fair value; under fair value there is no starting point that is as clear as historical cost.

What has actually happened over the past 20 years or so is that the emphasis of financial reporting (as determined by FASB) has shifted from the elimination of alternative accounting methods and control of fraud in the day-to-day operations of a business to an economic view of "values" for use by the stock market in evaluating investments without regard to managements' need for a control system for the company's normal operations. The result has been such standards as SFAS 133 (derivatives), SFAS 142 (goodwill, which allows the amortization to be whatever you want it to be), SFAS 144 (impairment of long-lived assets), and the most-recent proposal covering fair-value measurement, none of which are needed to run the day-to-day operations or that provide data for measuring the performance of employees that provide needed internal control of operations.

While the debate concerning fair value may continue with regard to public companies, it is not relevant to private companies. If I owned a company alone (or even with a few partners) I wouldn’t restate my securities every quarter under SFAS 133. As the owner I would evaluate my risks, of course, but I would not befoul the control system with the analyses. If I thought I wanted an audit, I would take the qualification from the fair value of GAAP.

Eugene H. Flegm, CPA, CFE
Bonita Springs, Fla.

The writer was the general auditor for General Motors Corp. before his retirement. His article “Accounting at a Crossroad: Preserving an Independent Profession” (The CPA Journal, December 2005) won the Journal’s 2005 Max Block Distinguished Article Award for the Best Article in the Area of Policy Analysis.

Regarding ‘Assessing Materiality: A New “Fuzzy Logic” Approach’

In “Assessing Materiality: A New ‘Fuzzy Logic’ Approach” (June 2006), the article’s introductory explanation to fuzzy logic was informative; however, some ideas with respect to auditing standards and their applicability should be clarified. The authors indicate that “in practice, an auditor must make an oversimplified binary decision” about materiality.

Professional standards and practice dictate that both qualitative and quantitative considerations be included in assessing whether a misstatement is material. At times, this might appear as a bypassed opportunity for auditors to incorporate qualitative analysis in their assessment of materiality. In practice, however, this process is often utilized. Accordingly, it is not clear on what basis the authors indicate, “Auditors tend to view materiality as a quantitative concept.” Is there cited research to support this statement?

Seasoned auditors would know that material misstatements and possible misstatements should be taken as a whole. At the conclusion of their audit, auditors are required by professional standards to assess the possible materiality of the aggregate of possible misstatements. Accordingly, if several possible misstatements are below the materiality threshold their aggregate may still be considered a material misstatement.

The use of fuzzy logic is appropriate in many situations. The application of fuzzy logic changes the questions from, “Is it material?” (the answer can be “yes” or “no”) to, “How material is it?” (the answer can range from 0% to 100%). However, this format has limitations. Specifically, our legal system may not be positioned to accept a level of ambiguity about such matters. The question of materiality is important to auditors, who put their name out to the public to attest that the users of financial statement may rely on the assertions in the statement in all material respects. In legal terms, the reliance on materiality is fundamental to the degree of responsibility auditors may take on their attestation. Modifying the definition of materiality could have grave consequences to auditors if it does not stand in court.

Finally, the construction of fuzzy-logic expert systems is well understood. However, expert systems are often used in homogeneous situations. Fuzzy-logic expert systems work best with events that tend to repeat within a certain domain of results. In these domains, expert systems can be constructed around repeated trends and understanding of the domain of possible outcomes. However, financial statements and audits are anything but a domain of limited outcomes; each engagement and each financial statement has unique and dynamic characteristics and challenges. Expert systems will be hard pressed to accommodate each and every audit engagement with its unique environment, period-to-period adjustable variables, and new variables. Although in theory this can be accomplished, I am afraid the cost would be substantial on a per-engagement basis. Coupled with the possibly weakened legal position, this approach may not be practical.

Yigal Rechtman, CPA, CFE, CITP, CISM
New York, N.Y.

The authors respond:

The writer expresses several valid concerns relative to the use of fuzzy logic in assessing materiality. We agree completely with the point:

Seasoned auditors would know that material misstatements and possible misstatements should be taken as a whole. At the conclusion of their audit, auditors are required by professional standards to assess the possible materiality of the aggregate of possible misstatements. Accordingly, if several possible misstatements are below the materiality threshold their aggregate may still be considered a material misstatement. [emphasis added]

In fact, in his first paragraph the writer quotes a portion of a sentence in our article: “The authors indicate that ‘in practice, an auditor must make an oversimplified binary decision’ about materiality.” The entire sentence in the article actually reads:

In practice, an auditor must make an oversimplified, binary decision for each omission and misstatement, both individually and in the aggregate: It is either material or it is not. [emphasis added]

So we most certainly acknowledge that seasoned auditors need to assess materiality both for individual misstatements/omissions and by aggregating all of the potential misstatements. Our original manuscript included a comprehensive case study that contrasted the classical system of assessing materiality with the fuzzy logic approach. This case study, excluded due to space constraints, included an example of a retail company with a detailed set of financial statements and four potential misstatements. The auditor was examining a credit sales overstatement, allowance for bad-debts understatement, inventory overstatement, and accrued interest understatement. Each misstatement was assessed for materiality using two quantitative considerations: 1) Did the amount of the misstatement exceed planning materiality, and 2) Could it be precisely measured. In addition, there were four qualitative considerations: If the misstatement were corrected did it: 1) reduce earnings per share below the consensus analyst earnings forecast; 2) change net income to a net loss; 3) reduce the current ratio below the level required to be maintained to comply with a loan covenant agreement; or 4) increase management compensation. These misstatements were examined individually and in aggregate. Based on the facts in this example, a reasonable auditor would have likely concluded that the understatement of the allowance for doubtful accounts might be material because it could not be measured precisely, and that the credit sales overstatement might be material because it increased management compensation. The misstatements were not likely to be considered material even when aggregated. This contrasts with the auditor’s decision using fuzzy logic, in which all of the misstatements would be considered material based on their qualitative factors. So the example illustrates that fuzzy logic techniques may lead to the identification of material misstatements/omissions when classical techniques indicate otherwise.

The writer also points out that fuzzy logic may have limitations because of the following:

Specifically, our legal system may not be positioned to accept a level of ambiguity about such matters. The question of materiality is of import to auditors, who put their name out to the public to attest that the users of financial statement may rely on the assertions in the statement in all material respects. In legal terms, the reliance on materiality is fundamental to the degree of responsibility auditors may take on their attestation. Modifying the definition of materiality could have grave consequences to auditors if it does not stand in court.

True, auditors must be aware of possible litigation risk, and thus any techniques they use in their audit, especially in an area as important as materiality assessment, must be substantiated. However, we do not see the use of fuzzy logic in assessing materiality to be problematic in this sense. We are suggesting the use of fuzzy logic to help the auditor identify material misstatements/omissions that might be assessed as immaterial using the classical approach. If an auditor does consider something to be material, she will most likely ask the client to correct the misstatement. In fact, in SAB 99, the SEC recommends that the auditor encourage the client to adjust even immaterial items.

We are not suggesting in this article that an auditor who has determined that an item is material using the classical approach then follow fuzzy logic rules that consider it immaterial. What is more realistic, and what we are suggesting here, is that fuzzy logic rules can help the auditor detect material items that under classical techniques would be considered immaterial. Thus, we propose the use of fuzzy logic to help reduce the auditor’s risk, not increase it. If the auditor uses fuzzy logic and finds something to be material that had previously considered immaterial, the worst that could happen is that the auditor may have to investigate further and do more work, or have the client adjust even immaterial misstatements. These steps would not increase the auditor’s litigation risk in any way. Rather, fuzzy logic techniques help the auditor be more conservative in the audit, thereby reducing audit risk and hence litigation risk.

Finally, the writer raises another valid concern, that fuzzy-logic expert systems generally—

work best with events that tend to repeat within a certain domain of results. In these domains, expert systems can be constructed around repeated trends and understanding of the domain of possible outcomes. However, financial statements and audits are anything but a domain of limited outcomes; each engagement and each financial statement has unique and dynamic characteristics and challenges. Expert systems will be hard pressed to accommodate each and every audit engagement with its unique environment, period-to-period adjustable variables, and new variables. Although in theory this can be accomplished, I am afraid the cost would be substantial on a per-engagement basis.

We completely agree that each audit engagement is unique, but similar circumstances exist in other areas in which expert systems can be useful. An expert system does not replace expert judgment but rather captures criteria based on input by real experts that can be standardized from case to case. A physician, for example, may ask a standard set of questions of a patient when diagnosing an illness, and thus a physician’s input is needed to build an expert system to diagnose certain diseases. Expert systems are rarely used as substitutes for human judgment; rather, they provide additional tools to aid human experts in carrying out their tasks. An expert fuzzy-logic system that can help the auditor assess materiality must be built using input by expert auditors, and would allow the auditor to enter certain unique criteria or validities that relate specifically to the audit firm’s criteria or those of the client.

In summary, fuzzy-logic expert systems to assess materiality are not intended to be used blindly by the auditor or to replace traditional tools, but rather to be used in conjunction with other tools to help improve the materiality assessment process, primarily for the purpose of identifying material items that might otherwise have been considered to be immaterial.

Rebecca L. Rosner, PhD, CPA, CISA
Christie L. Comunale, PhD, CPA
Long Island University–C.W. Post Campus, Brookville, N.Y.
Thomas R. Sexton, PhD
Stony Brook University, Stony Brook, N.Y.

Regarding ‘Functional Expense Reporting for Nonprofits’

I found “Functional Expense Reporting for Nonprofits: The Accounting Profession’s Next Scandal?” (August 2006) to be very well written and informative, the kind I have come to expect from your journal. However, on the practical application front, I have some problems with implementation of one of their comments.

According to the article, donated facilities and services are not always properly reported. It goes on to state that “CPAs should urge nonprofits to adopt staff timesheets and to use them for functional-cost allocation.”

Staff members at our nonprofit customers do that at this time; however, a very large portion of the services are by unpaid officers and directors, particularly for fundraising. Should unpaid officers and directors now be required to submit timesheets, and should a value be put upon them?

Philip Beckett, CPA
Gloversville, N.Y.

The authors respond:

Answering this question well requires more-detailed information. Our article recommends only that GAAP and IRS rules be followed. If the services contributed by unpaid officers and directors meet one of the two tests of SFAS 116, paragraph 9, they should be recognized as revenue in financial statements, and some sort of timesheet system for these volunteers would make sense. The tests are if the services “create or enhance nonfinancial assets” or “require specialized skills, are provided by individuals possessing those skills, and would typically need to be purchased if not provided by donation.” Board members making phone calls to ask for money or organizing a fundraising dinner would not meet these tests. A board member who is a lawyer providing pro bono legal services would.

If the services do not meet the tests of SFAS 116, paragraph 9, then, according to paragraph 10, “Entities are encouraged to disclose the fair value of contributed services received but not recognized as revenue if that is practicable.” This encouragement is not a requirement.

Under IRS rules, all contributed services are excluded from both revenue and expense; however, our article details the places on Form 990 where the value of contributed services is to be disclosed, to the extent the organization has a reasonable basis and documentation to support the amount reported. This can include amounts measured under either paragraph 9 or 10; therefore, the voluntarily disclosed amount may include volunteer services not recognized as revenue under GAAP.
In an ideal world, it would be “practicable” to measure and disclose the value of all contributed services. In the meantime, we would be satisfied if current GAAP and IRS requirements were met.

Kennard Wing, CMA
Kennard T. Wing & Co., Havertown, Pa.
Teresa Gordon, PhD, CPA
University of Idaho, Moscow, Idaho
Mark Hager, PhD
Center for Community and Business Research, Institute for Economic Development, University of Texas at San Antonio
Thomas Pollak, JD
National Center for Charitable Statistics, the Urban Institute, Washington, D.C.
Patrick Rooney, PhD
Center on Philanthropy, Indiana University, and Indiana University–Purdue University, Indianapolis.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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